Monday, August 5, 2013

Keynes was wrong, Hicks was right. Let's just get that out there up front.

LK shares a passage from Colin Rogers on the subject and concludes with "Perhaps this is why those coming from the New Keynesian perspective will be puzzled by attacks on loanable funds theory in critiques of the Austrian business cycle theory."

Nobody is puzzled. It's perfectly clear that Keynes was adamant that he didn't like how Hicks brought loanable funds back in and it's also perfectly clear that sometimes Post-Keynesians like to make a big deal of this. We just think clinging to this idea that loanable funds is a fallacy is wrong.

Let's imagine there are only two places to put your money: in a mattress and in a bank. Your time preference is going to determine how much money you save, in total, to use in the future rather than to use today. But there are reasons you're going to want to stay liquid too. It makes the most sense to think of liquidity preference as a demand for an amount of liquid assets, and not a share of your savings.

So if s is savings, m is mattress money, and b is bank money then b = s - m where m = l(x), it is equal to a person's liquidity preference which is a function of a vector of variables including the interest rate. So b = s - l(x), and presumably l(x) is decreasing in the interest rate (that's the opportunity cost of liquid money - this is the liquidity preference theory of interest). s is also increasing in the interest rate assuming the substitution effect dominates the income effect because s is determined by time preference and a higher interest rate acts like a reduction in future prices (that's loanable funds). So b is increasing in the interest rate because of both liquidity preference and loanable funds.

That sounds like an upward sloping loanable funds supply curve to me (because b is what we actually lend). I hope we don't have to demonstrate that the demand for loanable funds is downward sloping.

This mixes up the liquidity preference and time preference effects together. Hicks probably did it an easier way by just presenting things in terms of the bond market. But one of the reasons why I think Keynes's discussion is more natural to people is that he talks a lot in terms of personal savings which people relate to better.

So when Keynes gets all bent out of shape over Hicks, he's clearly the one in the wrong.

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New Keynesians or Neoclassical Synthesis Keynesians are no more "bastard Keynesians" for thinking this than Post-Keynesians are for their various departures from Keynes himself. The biggest departure was probably from Keynes's assumption of competition. This was deeply opposed by the Post-Keynesians but of course that flies under the radar because Neoclassical Keynesians seemed to have had the common decency not to run around making accusations of "bastard Keynesianism" and seeking to factionalize the science the way a lot of Post Keynesians do.

On this point I think Keynes was wrong too - and of course New Keynesians agree with Post Keynesians on this point. In fact, New Keynesians are more true to the early Post Keynesian thinking on it insofar as their principal way of dealing with departures from competition is by using models of monopolistic competition, which was one of Joan Robinson's most important contributions to economic science! It's the Post Keynesians that dropped all that and went backwards from an actual theory of market power to Marxian and Kaleckian assumptions about mark-up rates that are just applied to costs. To be clear - everyone agrees on firm mark-ups, the question is whether you take that to be exogenous or not.

So all this fuss about who is the truest to Keynes is pretty stupid. Everyone likes some things he thought and doesn't like other things, and the only reason why Post Keynesians sometimes feel like they're on a pedestal is because New Keynesians are too busy doing economics to knock them off it.

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One more point. Below is Giuseppe Fontana's adaptation of an endogenous money model you can find from Palley and elsewhere in the Post-Keynesian literature (this is from a 2004 Metronomica article - "Rethinking Endogenous Money", 55:4). Notice what's in the upper right quadrant? Yup. A loanable funds market.

Ooops.

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LK and I are internet buddies. This is just a disagreement. But there are grouchier Post Keynesians out there that may get a whiff of this post and not know me better. So it's worth noting that I don't really think of myself as a "New Keynesian", I'm just an economist (a labor economist actually, that does some macroeconomics) that's a Keynesian in the sense that he's the guy I most identify with. I value New Keynesian contributions, but I'm from a heterodox department (AU) and I value a whole lot of Post Keynesian work too.

But one thing I don't do is play this game of pitting heterodox economics against mainstream economics the way a lot of heterodox economists like to do.

Don't think of them like axes - think of them as four quadrants of four different Cartesian planes butted up against each other. It's a convenient way to map multiple relations onto each other and confirm whether you're in an equilibrium or not.

Thanks for the help, though I can't help but think (rightly or wrongly) of the y-axis and x-axis. Anyway, with regard to the book by Colin Rogers that Lord Keynes cites...here's a book review of it that others may find interesting.

I always took the point Keynes made about loanable funds/endogenous money was not that there is no loanable funds market and/or it is not that there are obviously sloped demand and supply curves, but that you cannot get any information about the relationship of interest and investment out of a loanable funds model because it is impossible to hold one curve constant. That renders loanable funds useless for economic modeling. Hicks hand waves this objection in his paper when he builds his IS curve.

That graph above does not contradict this. Loan supply has to be infinitely elastic to generate meaningful predictions about loan demand and supply. Which again seems to be the main Post-Keynesian point here and I think its the most important contribution of PK economics.

I just relooked at Hicks 1937 (because I have more important things to do) and I think my basic point stands. Hicks presents the case of endogenous savings (Which gives you a downward sloping IS curve automatically) but dismisses it in favor of the more "mathematically elegant" model which makes savings a function of the interest rate. He then has to impose the assumption that savings will shift by less than investment in order to get a downward sloping IS curve.

Anyway, whether liquidity is driven by a desire for a fixed amount of liquid assets or a share of income is an empirical matter, and my money is on the demand being proportional. You are also ignoring the fact that today's endogenous money theory hinges on the ability of banks to create their own liabilities through asset creation. You are entirely relying on the assumption that savings can only be generated by households to make your argument.

Proportional to income, but I doubt proportional to savings which is what I said. But you're right, it's an empirical matter. Anyway everything I said here could be rewritten with proportional to savings, but there's no real point in doing multiple case.

I'm not relying on that assumption. There's no reason what I've said has to concern households at all, except the reference to "mattresses". You can say cash instead - that's just vivid imagery :)

On Hicks - right, we can talk about different types of curves and this has been the subject of a fair amount of blogging in the last couple years. But the point is that you can't pin it down without liquidity preference theory (and of course, if we're entertaining other curve shapes, when you "pin it down" that may not be stable).

In any case though...after re-reading this post, I have something to say with regards to J.M. Keynes, J.R. Hicks, and the IS/LM model.

Can you please point me to the exact parts of the CWJMK where J.R. Hicks and J.M. Keynes correspond with each other on this matter, Daniel?

AFAIK, J.M. Keynes didn't exactly say to J.R. Hicks that the IS/LM model was absolutely useless. In the second volume of Lord Skidelsky's three-part biography of J.M. Keynes, he suggests that J.M. Keynes acquiesced to it as a useful compromise.

It sounds like you're talking about a pot of gold that gets passed around - i.e. a quantity of 'funds' that can be saved and then loaned. But this isn't the case, is it.

The term 'loanable funds' seems to inspire completely illogical statements from people, such as "we need to increase our savings so that we have more (loanable) funds to invest"

That's just nonsense, isn't it?

You don't need more 'savings' before you can increase investment - investment creates savings. And trying to increase savings on its own can reduce demand, and thus reduce income and investment... So the whole concept of 'loanable funds' can quickly become self-destructive when misunderstood (and the term encourages misunderstanding).

My understanding is that 'funds' aren't really 'lent'. Instead lending creates 'funds' that can be saved (I might be wrong, please correct me if I am).

Perhaps a new term would be better; something like "a balance between investment and savings", rather than "loanable funds"... ?

The problem with the Post Keynesian or Neo-Chartalist theory that you describe is that there are limits restricting it that are often omitted.

Let's say I'm the manager of a bank. I get my loan officers to make loans for £1M. Loan contracts are drawn up, then that money is created by putting an entry in the bank accounts of the borrowers. That step is unrestricted and that's the step that the one lots of people concentrate on. Now savings exist in the accounts of the debtors and the bank owns assets in the form of the loan contracts. Next though, the borrowers will start to spend their money. Money that's has been saved in a bank account normally is not spent quickly, but money that has been borrowed is generally spent very quickly. People generally borrow money in order to spend it straight away. It's most likely that the borrower will spend the money buying from an organization that banks with a different banks. So, when a borrower spends their money the bank must transfer base money to another bank. The bank must supply base money, i.e. cash or reserves, banks don't generally accept balances at other banks as payment. What this often means in practice is that a bank must obtain reserves before it can make loans, because as soon as the loans are made the reserves must flow to other banks. Therefore a bank must save reserves before it can make loans. Notice that it can't "double book" reserves, if some base money is needed for operations (such as making payments) then it can't use that base-money again to supply to other banks. Similarly, if some reserves are needed to satisfy a reserve ratio then those reserves can't also be used to send to other banks. Or, at least, as soon as they are they must be replaced by other reserves bought or borrowed from elsewhere. Of course this means that if a bank has more reserves than it needs then it can make loans with no cost.

This has happened quite a lot recently which has encouraged people to think that think that this is always the case. Really, what's happening in this case is that the bank itself has been saving. Then when it makes loans that's the bank spending it's savings.

"extra reserves to settle payments it can borrow them from other banks or from the central bank."

You're just punting the problem to a different bank. Excess reserves at these other banks are also the savings of banks too. Obtaining them costs money in interest payments.

"In this way deposits originally created by loans end up being saved."

Sort of. As I said earlier banks don't hold balances at other banks. In that case you're talking about bank X creates a balance by creating a loan. Customer #1 then withdraws that balance as base money. He then spends it on something, passing it to customer #2. Customer #2 banks with a different bank, he deposits the money in bank Y. That means bank Y put a number next to his name in some database. If customer #2 keeps his money there for a long enough time then that bank can use the base money they've obtained for making loans. But, if customer #2 spends it straight away then that bank has to pass the base money right on to somebody else.

Fullwiler is right that banks can create balances before they have reserves. But, as he points out, the balances created by loans are mostly withdrawn and spent immediately after the loan is made. Once this happens reserves are needed. Fullwiler points out that the bank may borrow the reserves, but he doesn't present a "T-account" in his table 5 for the bank that provides those reserves. Doing so would demonstrate that another bank must have excess reserves that are available to borrow. He later implicitly admits this by saying "at the level of the individual bank, the act of lending is not deposit or reserve constrained".

He mentions that the borrower and the spending recipient may have the same bank. That's true, but it's unlikely to be important in practice, since the recipient is very likely to spend what he receives. For example, if I buy a house it's most likely that the homeowner I buy from will use the money I give them to buy another house soon afterwards.

"Even if they use different banks, daily flows into and out of a bank's reserve account are considerable, and the bank may not actually end the day with a net outflow (and even in that case, it might already have sufficient balances to not end the day with a negative balance or short of its desired level for meeting reserve requirements)"

This is gambling. He's right that the flows he discusses are variable, but each work by the process that we've discussing. Just as the variability in the flow may lead to more reserves, so they may also lead to less. It would be unwise to gamble that it will always lead in the same direction every time.

Where Fullwiler is right he's arguing against things that nobody thinks, his "endogenous money" view is the same as the conventional view. Everywhere else he's wrong.

You need to keep reading where I explain the role of the CB in all of this, which gets at all of your straw man criticisms. That is, you've set up a straw man by suggesting I didn't go beyond an individual bank. In fact, there are about 6 sections of the paper, and only one discusses one bank alone, simply for the purpose of understanding the bank's view. The CBs fundamental role--which all CBs recognize--is to sustain the payment system. They do this by setting an interest rate and letting the qty of reserve balances float. This means--by definition--that the qty of reserve balances never restricts bank lending in the aggregate. And thus, an individual bank can always obtain balances from another bank or the CB, and "another bank" similarly can always do the same. The system as a whole, then, can always obtain balances from the CB at its stated target rate.

Also, what I refer to in your quote is not "gambling." It's called a netted payments system, and they exist all over the world. And, again, the CB provides at its target rate sufficient reserve balances to settle these netted payments every day.

You need to keep reading where I explain the role of the CB in all of this, which gets at all of your straw man criticisms. That is, you've set up a straw man by suggesting I didn't go beyond an individual bank. In fact, there are about 6 sections of the paper, and only one discusses one bank alone, simply for the purpose of understanding the bank's view. The CBs fundamental role--which all CBs recognize--is to sustain the payment system. They do this by setting an interest rate and letting the qty of reserve balances float. This means--by definition--that the qty of reserve balances never restricts bank lending in the aggregate. And thus, an individual bank can always obtain balances from another bank or the CB, and "another bank" similarly can always do the same. The system as a whole, then, can always obtain balances from the CB at its stated target rate.

Also, what I refer to in your quote is not "gambling." It's called a netted payments system, and they exist all over the world. And, again, the CB provides at its target rate sufficient reserve balances to settle these netted payments every day.

So, what you're saying is that Central Banks always offer more reserves at an interest rate, that's the basis of everything else you say. Certainly, I agree with that, but how is that unconventional monetary theory? It sounds pretty ordinary to me.

"Also, what I refer to in your quote is not "gambling." It's called a netted payments system, and they exist all over the world."

Sure. I agree that the bank may not end the day with a net outflow. But the real question is why should a particular bank repeated be in this situation? Just a chance will often push the flow of reserves in the opposite direction. I don't see why a net inflow is more likely than a net outflow.

A bank can be capital-constrained, not reserve-constrained. That's the Endogenous Money view. Bank deposits or money held at the Fed do not count as capital. So thus when banks are in periods of having a poor balance sheet, a bank is likely to be much more conservative with its credit requirements for borrowing. When a bank's balance sheet is completely underwater, it becomes a zombie bank like what you saw during Japan in the 1990s and what Citibank was for awhile. It's not like there isn't instability in a credit-based economy, and this is a huge part of the Minskyan PK wing when too much credit is created and/or assets become depressed. It's not like PKs haven't thought of this stuff before.

"A bank can be capital-constrained, not reserve-constrained. That's the Endogenous Money view."

Certainly a bank can be capital constrained or reserve constrained. That's independent of endogenous money, so let's not mix up the two.

"Bank deposits or money held at the Fed do not count as capital"

Balance sheets are tricky things. If you own something then that's your asset. If someone owes you something then that debt is your asset not your liability. You can see reserves as assets of a commercial bank, or you can see them as something owed to that bank. Either way, they are assets not liabilities and that means if a bank owns reserves then they are the savings of that bank. We can talk about the oddities of accounting for cash on balance sheets if you like, it doesn't change anything important.

"It's not like there isn't instability in a credit-based economy, and this is a huge part of the Minskyan PK wing when too much credit is created and/or assets become depressed. It's not like PKs haven't thought of this stuff before."

I agree that there is instability, but we have to agree about the fundamentals before we can talk about the more complex aspects of it.

You write, “Keynes was wrong, Hicks was right,” and then aim to prove it with a simple model, “Let's imagine there are only two places to put your money: in a mattress and in a bank.”

I don’t think this model is up to the task you’ve set for it. In the GT, Keynes divides the demand for money into three parts: 1) money demanded for transactions; 2) money set aside for precautionary purposes; and 3) money held for speculation. You’ve got 1 and 2 more or less covered, but you’re missing 3 because you’ve excluded bonds.

If someone expects interest rates to rise and bond prices to fall, they’ll sell some (or all) of their bonds and hold bank deposits or mattress money instead. If a preponderance of bondholders share this bearish view, then interest rates will fall. On the other hand, if wealth-holders are bullish and expect bond prices to rise, they’ll buy bonds and interest rates will fall.

You claim that “it makes the most sense to think of liquidity preference as a demand for an amount of liquid assets, and not a share of your savings.” In this case, you seem to be thinking of a precautionary motive, e.g., “I should keep some money handy for emergencies.” But this doesn’t really capture the essence of Keynes’ speculative motive wherein “I hold cash rather than bonds because I think interest rates will rise and don’t want to suffer losses on my bond holdings.”

Taking a step back, the loanable funds theory tends to be a theory about flows of loanable funds (saving less mattress money) and the flow of investment or borrowing demand. For Keynes, by contrast, the dominant factor revolves around the stocks of various kinds of asset. For example, the volume of existing bonds that can be released upon the market swamps the volume of newly issued bonds. Hence the expectations of those who would buy or sell the existing stock of bonds has a far greater effect on the interest rate the current flows of saving and investment demand.

I haven’t looked at Hicks for awhile, but I think his second thoughts about ISLM concern, in part, the uncertainty it leaves out of the picture.

What you're discussing is mostly about explaining the different interest rates that are charged on different debt instruments, such as notes, bank balances and bonds. But, all of these things are "savings". Our theory of them should define several interest rates that depend on the things you're discussing.